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Research Highlights 2008: Macroeconomics and Growth

Growth is essential for sustained poverty reduction, the Bank's paramount objective. The research program aims to guide policies and reform strategies conducive to sustained high growth. To do this, research seeks to identify the factors behind the diversity in aggregate economic performance across the world and understand how it is affected by policy and institutional changes under different country circumstances.

Themes

The research program explores the micro- and macroeconomic foundations of growth and aggregate economic performance. It has an empirical orientation and draws from a wide range of data sources—from firm surveys to national macroeconomic data, as well as simulation models. Current research on growth seeks to understand how policy actions and reforms translate into growth, with special attention to the role of country-specific initial conditions and complementarities among different policies.

Ongoing work explores the determinants of firm behavior and microeconomic efficiency and their contribution to aggregate economic performance, as well as the effects of the policy and institutional environment on innovation and technological upgrading.1,2 Work on the growth effects of macroeconomic policies investigates the consequences of fiscal and exchange rate policy for long-term growth.3,4

Research on aggregate volatility and macroeconomic stabilization examines the contribution of policy and other forces (from external shocks to natural disasters) to economic fluctuations, and their consequences for growth and welfare. It assesses reforms to reduce the aggregate instability through suitable fiscal and financial policies, as well as policy measures to tackle microeconomic inflexibility.5

The opportunities and risks posed by deepening international economic integration represent a major research theme. Access to external financing broadens firms' and countries' investment and risk diversification possibilities, but it also increases their vulnerability to global disturbances in real and financial markets. Research assesses these conflicting effects and the trade-offs between them. It also examines the mechanisms of international propagation of shocks under different policy and institutional conditions, to identify suitable risk-management strategies for developing countries.6,7

Research on the role of governance and institutions for sustained growth draws on both aggregate and micro to assess the effects of governance, determine the channels through which it affects economic efficiency and aggregate growth, and identify the institutional and political economy factors, such as citizen information and political accountability, that contribute to goodgovernance.8,9,10 Ongoing work on conflict and violence assesses the policy and institutional strategies conducive to sustained peace and development in countries emerging from conflict.11,12

Highlights

The growth effects of trade reform depend on accompanying measures

Although on average trade reform has been found to promote growth, the evidence shows a large degree of heterogeneity in its effects. The reason is that the ability of reforming countries to take advantage of increased international competition and access to foreign markets depends on complementary reforms and structural factors that shape the availability of productive inputs— such as human capital and infrastructure services— and the ease with which they can be reallocated to their most productive uses following trade reform—as determined by labor market flexibility, financial market development, overall governance quality, and the extent of barriers to firm entry and exit. International evidence shows that the growth payoff from trade reform is significantly bigger when the removal of obstacles to trade is accompanied by complementary domestic reforms in these areas.13,14

Global integration has promoted contagion of real and financial shocks

Emerging market crises in the 1990s generated widespread contagion, but more recent crisis episodes (notably, in Argentina) were mostly contained within national borders. Some observers concluded that in the 2000s financial markets had learned to discriminate between emerging countries with good and bad fundamentals, making contagion a thing of the past. However, closer inspection of trade and financial data reveals that the main channels of transmission of turbulence across countries—international trade linkages and the portfolio positions of international investors— are actually stronger today than they were in the 1990s, thus enlarging the room for the rapid propagation of shocks. These conclusions have been borne out by the current global crisis.15

A growing number of firms simultaneously receive credit from their suppliers and grant it to their customers, and this makes trade credit a potentially important—but often neglected—mechanism for the propagation of idiosyncratic shocks. The intuition is simple: a firm facing default by its customers may run into liquidity problems and default on its own suppliers. International evidence on the co-movement of output across different industries shows that an increase in the use of trade credit along the supply chain linking two industries significantly increases the correlation between their outputs, confirming that trade credit does help propagate sector-specific shocks across industries.16

To stem contagion, countries sometimes resort to capital controls, but their effectiveness remains controversial. The fact that major emerging-market stocks trade in both domestic and international markets allows a direct assessment of the effects of capital controls. In their absence, price deviations across markets are rapidly arbitraged away, particularly for liquid stocks. But barriers to cross-border capital flows effectively segment markets: controls on capital outflows induce positive premia between domestic and foreign markets, while controls on inflows have the opposite effect. The size of these premia varies with the intensity of capital controls.17

Fiscal policy choices are largely shaped by political incentives

Traditional wisdom holds that runaway public spending is more likely to arise under elected multi-party coalition governments than under single party governments, and that politicians strongly favor pork barrel spending, even when other spending on broad public goods would be socially preferable. New research overturns both of these views. First, coalition governments are likely to tax and spend less than single-party regimes.18

The reason is that parties seeking to govern without coalition partners have to spend more universally, to win the support of "swing voters" unattached to political parties. This suggests that in single-party regimes fiscal responsibility may be better enforced by an independent agency than by the finance ministry. Second, data from Indian districts show that political parties can help limit politician bias toward pork-barrel spending: members of parliament spend less of their constituency development funds when they are from districts where their parties are strong.19 Political parties may have greater incentives than individual legislators to provide broad-based public goods; when they do, these party-enforced constraints on spending are welfare-improving.

17. Eduardo Levy Yeyati, Sergio L. Schmukler, and Neeltje Van Horen. Forthcoming. “International Financial Integration through the Law of One Price: The Role of Liquidity and Capital Controls.” Journal of Financial Intermediation.

19. Keefer, Philip, and Stuti Khemani. 2009. "When do Legislators Pass on Pork? The Role of Political Parties in Determining Legislator Effort." American Political Science Review 103(1): 99-112. (SSRN Working paper version)